This page is for comments and discussions on the topics of We Are Different.
April 6, 2001. By author.
It's a Friday. The U.S. stock markets ended this week near the new lows on their way down from the all-time highs, which were reached in the earlier part of the year 2000. It seems to be an opportune time to review the state of the markets. We will do this in light of the chapter Dynamics and the case study The Equity Markets' Bubble in We Are Different, So What.
The price-to-book ratio is the most fundamental of the stock market measurements, the other fundamentals being the price-to-earnings ratio and the dividend yield. If a business is valued in the market well above what it has cost to the owners to establish it, this creates a strong incentive to other entrepreneurs to create a similar business and, in a short while, bring it to the market, e.g. through an initial public offering (IPO), thus, enriching themselves in a matter of months. This is a mechanism for developing production overcapacities, slowly but surely. The current economic slow-down has been accepted, I believe, as a one caused by the overcapacities. The question is whether we have approached, or are close to the end of the stock markets' slide.
The sources of the data below are the Barron's Market Laboratory and the Long-Term Perspective charts of the Value Line Investment Survey. Just before the stock market crash in 1929, the price-to-book ratio for the Dow Jones Industrial Average (DJ) had risen to 4.18, the value unseen until then. By the end of the market descent in 1932, the ratio had fallen to as low as 0.50 and the DJ had lost close to 90 percent of the value. In the post-war period, from 1946 to 1982, the ratio had been in the range from 0.77 (in 1974) to 2.14 (in 1964 and 1965). In 1982, the longest climb of the North American markets started. In October of 1996, the DJ price-to-book ratio stood at 4.48, exceeding noticeably its value at the 1929 peak.
In January of 1999, when we released The Equity Markets' Bubble on our website, the ratio stood at 6.05. One possibility we presented was that the Y2K problems might have triggered the bubble's burst. Luckily, Y2K had turned out to be a non-event, and the feast continued uninterrupted.
In January of 2000, at DJ's all time high, its price-to-book ratio reached somewhere between 6.94 and 7.37, depending on what precisely its book value was at that time. Today, by the accepted convention (20 percent or more below the previous high), the S&P 500 and NASDAQ indices are already classified as bearish. The DJ came within 1 percent of this during the week of March 19-23. Still, the lowest value that the DJ price-to-book ratio has lately touched is 5.80.
With these numbers, I challenge you to make your own judgement as to the possible paths of the U.S. stock markets over the next two or three years.
The Federal Reserve Board might, and hopefully will be successful in keeping the U.S. economy much more stable than was the case in 1929-1932. But the stock market has a mind of its own. At the unsettling times like we have now, it is driven to extremes by mass psychology. If history is of any guidance, a drastic over-evaluation would not end with the market descending just to a state of normality. The sling-shot effect would push it to the opposite extreme. A year ago, technology buffs were proclaiming that the New Economy oughtn't to comply with the laws of economics. With the NASDAQ market down 65 percent and more, we do not hear from them any more. These days, as the drop in the U.S. stock markets is worrying many investors, a couple of prominent prognosticators have already promised us that the bottom is near. We also hear from others that some historical correlations point to a major reversal. As it is said, the stock market has fooled everyone.
The thing is that by the most fundamental of the measurements, the U.S. stock markets remain hugely over-valued. This state, regardless of the considerable last-year declines, is unprecedented. Thus, it is doubtful that any empirical observations apply. For this reason, our approach, as presented in the chapter Dynamics of We Are Different, is not empirical. It is rather based on some general mathematical properties of multi-dimensional dynamic systems.
Older entries were deleted on April 11, 2009, as obsolete.
A cosmetic modification to this page on November 8, 2009; no changes at all to the comment of April 6, 2001.